Working Paper

Capital Controls and the Global Financial Cycle

Abstract: Capital flows into emerging markets are volatile and associated with risks. A common prescription is to impose counter-cyclical capital controls that tighten during economic booms to mitigate future sudden-stop dynamics, but it has been challenging to document such patterns in the data. Instead, we show that emerging markets tighten their capital controls in response to volatility in international financial markets and elevated risk aversion. We develop a model in which this behavior arises from a desire to manipulate the risk premium. When investors are more risk-averse or markets are volatile, investors require a high marginal compensation to hold risky emerging market debt. Regulators are able to exploit this tight link and raise capital inflow controls, thereby lowering the risk premium and reducing the overall cost of debt. We emphasize that risk premium manipulations via capital controls are only optimal from the perspective of the individual emerging market, but not from a global perspective. This suggests that the use of capital controls may impose costs in an international context.

Keywords: Capital Controls; Risk Aversion; Risk Premium; Volatility;

JEL Classification: F36; F38; F41;

https://doi.org/10.18651/RWP2021-08

Bibliographic Information

Provider: Federal Reserve Bank of Kansas City

Part of Series: Research Working Paper

Publication Date: 2021-09-08

Number: RWP 21-08